week 1 discussion

week 1 discussion - The cost of common stock is defined by...

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The cost of common stock is defined by Brigham and Ehrhardt as defined as the “rate of return required by the firm’s stockholders” (Brigham and Ehrhardt 2011). Apparently, companies can raise their common equity in two ways: either by selling new shares of stock to the public or by retaining and reinvesting earnings. If the company decides to issue new stock, the question is, what is the rate of return that investors would require? This is termed rs. This approach is not used very often because of several reasons. The first of which, is that flotation costs are high. Flotation cost is defined as, “The costs incurred by a publicly traded company when it issues new securities. Flotation costs are paid by the company that issues the new securities and includes expenses such as underwriting fees, legal fees and registration fees. Companies must consider the impact these fees will have on how much capital they can raise from a new issue” (Investopedia) The second reason fewer than two percent of firms issue new shares of common stock through public offerings (Brigham and Ehrhardt 2011) is that investors view the issuance of new common stock as a bad sign about the true value of the company’s common stock. The logic is that investors believe that managers have more knowledge about the company’s future than the general public. If future prospects are not looking good, then these managers might issue new common stock to spread the financial decline amongst more shareholders. The third reason why investors view issuance of new common stock as a negative sign is the basic logic that an increase in the supply of stock will put pressure on the stock’s price, which forces the company to sell new stock at a lower price than before the new stock was issued (Brigham and Ehrhardt 2011). Finally, the second way that companies might raise their common equity is by retaining and reinvesting earnings. This brings about the concept of opportunity cost. Opportunity cost comes in to play when considering whether reinvesting earnings has a cost. The cost is opportunity cost, and stock holder incur this due to the fact that the earnings that were reinvested could have been paid out as dividends to the stockholders. The crucial point to make here is that ultimately, when a firm is retaining and reinvesting its earnings, the firm should earn at least as much or more as the stockholders would earn if they were to put that money into other investments with a similarly perceived risk. This is what is termed as rs. Thus, r is the cost of common equity raised internally as reinvested earnings. If a firm does not believe that they can achieve rs, then the firm should pass on reinvesting their earnings and pay the shareholders with dividends, and let them earn an rs of an worthy amount on their own. There are three methods used to determine this cost of equity, which is no simple task.
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week 1 discussion - The cost of common stock is defined by...

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